Features of Corporate Bonds explained

Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. An investor who buys a corporate bond is effectively lending money to the company in return for a series of interest payments, but these bonds may also actively trade on the secondary market.

Conventional bonds have two parts, the face value, or principal, and the coupons (interest). Corporate bonds are debt obligations of the issuer—the company that issued the bond. With a bond, the company promises to return the face value of the bond, also known as principal, on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually. A corporate bond does not give you an ownership interest in the company—unlike when you purchase the company’s stock.

Yield or YTM is the estimated internal rate of return earned by an investor who buys the bond today at the market rate. Yield tells the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity (YTM) is a critical concept in bond investing because it is the tool used to measure the return of one bond against another. It enables one to make informed decisions about which bond to buy.

Bonds are classified as short-term, medium-term, and long-term according to their maturity, which is the date when the company has to pay back the principal to investors. Maturities can be short-term (less than three years), medium-term (four to 10 years), or long-term (more than 10 years). Longer-term bonds usually offer higher interest rates but may entail additional risks.

Bonds are classified as investment-grade or non-investment-grade bonds. Investment-grade bonds are rated AAA to BBB, with BBB being the lowest and AAA the highest. AAA- AAA-rated bonds have the highest quality with the lowest risk of default. AA- AA-rated bonds are of high quality with a very low risk of default. A- Rated Bonds have an adequate degree of safety with a low risk of default. Investment-grade bonds are rated by credit rating agencies like CRISIL, ICRA, CARE, etc. based on their creditworthiness. These agencies evaluate the financial position and credit history of the issuer, among other factors, to assign a credit rating to the bond. This rating reflects the probability of the issuer defaulting on their debt obligations. Typically, investment-grade bonds are issued by entities with a stable financial position, a strong history of debt repayment, and a low likelihood of going bankrupt. Non-investment grade bonds, which are also called high-yield or speculative bonds, generally offer higher interest rates to compensate investors for greater risk.

 Bonds also differ according to the type of interest payments they offer. Many bonds pay a fixed rate of interest throughout their term. Interest payments are called coupon payments, and the interest rate is called the coupon rate. With a fixed coupon rate, the coupon payments stay the same regardless of changes in market interest rates. Another type of bond is a floating rate Bond. A floating rate bond does not have a pre-determined coupon rate. The issuer of floating rate Bonds resets the coupon rate regularly based on fluctuation in the prevailing market rates of interest or some other external measures. In India, floating bonds usually come with a spread concerning rates like Mumbai interbank offer rate (MIBOR) + say 45 basis points. It means that the coupon amount will change according to the prevailing MIBOR at the time of coupon payment. The investors of floating bonds buy them in anticipation of a hike in the reference rate so that they earn a higher coupon rate in the future. There are other types of bonds available in the market

Read:

1. WHAT IS A ZERO-COUPON BOND?

2. WHAT ARE FOREIGN BONDS, EURO BONDS, AND GLOBAL BONDS?

3. WHAT IS INFLATION INDEXED BONDS OR IIB?

4. WHAT IS YIELD OR YIELD TO MATURITY (YTM) OF BONDS?

5. CONVERTIBLE BONDS, FLOATING RATE BONDS AND NEGATIVE BONDS

6. DO YOU KNOW THE MEANING OF MASALA BONDS?

A committee was formed by the Government under the chairmanship of Dr. R. H. Patil to look into the factors inhibiting the development of an active debt market and recommend policy actions necessary to develop an appropriate market infrastructure for the growth of an active corporate bond market. A few of the recommendations for the development of an active secondary market for corporate bonds are:

• Establish a system to capture all information related to trading in corporate bonds as accurately and as close to execution as possible and disseminate it to the market in real-time.
• Clearing and settlement of transactions in this market must adhere to the IOSCO standards.
• Based on an increase of awareness amongst the participants to introduce an online order matching system.

The implementation of the above recommendations aimed at widening the investor base, improving liquidity, and encouraging companies to issue bonds.

The risk involved in corporate bonds:

When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up. As a result, if one sells a bond before maturity, it may be worth more or less than it was paid for. The long term bonds are most sensitive to interest rate changes. When inflation increases dramatically, bonds can have a negative rate of return. The relationship between bond price and interest rates is inversely proportional, that is, the fact that bonds are worth less when interest rates rise and vice versa.  This risk can be expressed as the volatility of the return. By holding a bond until maturity, one may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because one will receive the par, or face, value of the bond at maturity.